Central Bank Biases

Mr. Angeles is an entrepreneur, and author of books, “The Peso Exchange Rate: Why Are We So Poor?” and “The Philippine Economy: Do Our Leaders Have A Clue?” This was published in the September 21, 2009 edition of the Philippine Daily Inquirer, page B9.

DO NOT BE ALARMED. I AM not about to attack Bangko Sentral ng Pilipinas.

My title pertains to economic concepts espoused not just by central banks but also by leading economists all over the world.

The warning is very nicely put: If you do not believe these concepts, you must be an ignoramus.

Free market

I am starting with the concept of free market, Adam Smith’s “invisible hand,” and the assumption that a free market will work things out nicely in the end.

It wasn’t very long ago when we were advised by central banks, “Do not mess with the market!”
Well, the current financial crisis has put that concept to everlasting sleep. The US government, the bastion of free market, nationalized its leading banks and is now gearing up for more government intervention in the economy.

Reducing interest rates spurs growth in the real economy, encourages people to borrow and to increase demand, and results in higher level of economic activity.

It is a holy mantra among experts.

But look. The Fed Reserve has reduced Funds Rate close to zero almost a year now, but the US economy is still in recession and unemployment has risen to 9.7 percent.

From the New York Times in a Sept. 10 article: “The Fed and many private economists predict the jobless rate will hit 10 percent by the end of this year. The recession so far has eliminated a net total of 6.9 million jobs.”

Here is from an announcement of the National Employment Law Project dated July 24: “A sobering analysis released today by the National Employment Law Project estimates that 540,000 Americans will exhaust their unemployment insurance benefits by the end of September, and a whopping 1.5 million will run out of coverage by the end of the year.”

Now, here is for certain: As the cost of borrowing of fund managers went down, the US stock market experienced its best index last week for 2009 and cheap money continue to pour in the futures market raising the prices of metal and oil prices to the consternation of the unemployed in the real economy.

Here are my thoughts on reduced interest rates.

One, with insignificant interest income in bank deposits, people divert their savings instead to fund managers who in turn place them in stocks, currency and commodities markets.

Easy math
Two, companies with access to low-interest loans place their money in the markets for surer short-term returns.

It’s easy math. If their market returns yield a minimal 1 percent per month (very conservative indeed!) and their cost of borrowings is 8 percent per 12 months, would they not borrow and place their money in the markets?

Three, people in the real economy will not have easy access to cheap funds just because the Fed’s Fund Rate has gone down. Banks will continue to be conservative and selective in their lending policies irrespective of the Fed Funds Rate.

Result? The aim to spur the economy with reduced interests and flooding the economy with money does not connect with realities. It benefits only financial institutions.

Four, people who borrow and live a lifestyle beyond their means will soon face foreclosure proceedings. Such is the case of the millions of borrowers in the housing bubble and the credit card crisis.

Decreasing the cost of borrowings for these people won’t make them borrow again while their old loans remain unpaid and while they struggle with their livelihood and lives.

Their effort to curtail their spending will result in a decrease in demand in the economy.
This is as it should be; it is as natural as the cycle of ebbs and flows of tides.

But if these borrowers do increase their borrowings without any increase in their income, watch out for another financial tsunami!

Five, banks and financial institutions will look for alternative investment strategies with short-term returns at less risk—easy money.

What are these nontraditional investment strategies? Stock markets, foreign exchange markets, futures and options markets—derivatives!

It is easy to see the facts in this statement: The decreasing growth rate in the past 10 years of bank revenues from traditional businesses (lending to businesses and industries) compared with increasing growth rates of their nontraditional investments incomes.

The regime of very low interest rates leads banks astray from their principal raison for being: To support the development of the real economy from where they derive their existence.

Six, this is not to say I am for Jobo Bills of the early 1980s which raised interest rates beyond 40 percent and made businessmen think it was better to place their money in the bank that offered over 36 percent interest than to run their businesses.

I call for a balance between the interests of savers and of the industries.
Seven, central banks place too much correspondence between interest rates and inflation or so-called “negative interest rates.” High interests control inflation; low interests lead to inflation. Not necessarily. In the world today, the sure correspondence is this: Low interest rates fuel financial markets; high interest rates dampen financial markets.

But this is reserved for another article.

Easy money

We can understand why people misconstrue that low interest rates and flooding money in the economy lead to economic recovery.

After all, didn’t these stop the financial markets collapse made worse by the fall of Lehman Brothers? Don’t they fuel the spectacular performance of the US financial markets in the past eight months? Aren’t financial institutions executives in Wall Street about to earn their billions of bonuses again?

End of recession
Why, even Fed Reserve Chair Ben Bernanke himself declared Tuesday last week that it was “very likely” that the recession had ended although he cautioned that it could be months before unemployment rates dropped significantly.

Notice how the US Central Bank chair differentiates the ending of recession from the continued unemployment of people, as if they are not faces of the same coin.

Well, that is the Central Bank bias I refer to: The financial markets in Wall Street are king, while the welfare of the real economy in Main Street is something else!

To many, that makes me an ignoramus! Indeed!

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